Monday, May 28, 2012

Rate swaps have an embedded option to sue the bank

This happened in the US and is now happening globally. Municipalities, corporations, and even sovereign states who put on "hedges" against rising interest rates are suing banks because their hedges lost money. Let's see, you put on a position that will make money if rates rise, what do you think happens if rates fall?

10-year EUR swap rate

But that's OK because many organizations always have the option to sue the banks to recover these losses.

Bloomberg: - Unitech Ltd., an Indian property developer, accused Deutsche Bank AG of selling it an interest- rate swap that wasn’t suitable and wasn’t properly explained, according to a London lawsuit over a $150 million loan deal.

That's right, the hedge wasn't explained well. It's way too complicated. If interest rates rise, Unitech's property development funding costs go up and the swap makes them money to offset those incremental costs. If rates go down and funding costs decrease, the swap loses money and Unitech loses the savings from lower funding costs.

Or maybe they don't have to give up those savings after all - because they can just play dumb and default on the swap payments.

Unitech filed a counterclaim in May arguing Deutsche Bank was negligent to sell an unsuitable hedging agreement, and owed damages that canceled out its debt, according to court documents. Germany’s biggest bank had earlier sued Unitech saying a unit of the company owes $11 million under the swap contract and has missed payments.

Deutsche Bank “knew, or must have appreciated, that it was likely to make significant amounts of money” from the contract at Unitech’s expense, the Indian company said in its lawsuit.

Of course Deutsche Bank knew that rates will go down. They always know which way rates are going.

Interest-rate swaps that turned out to be costly for customers and profitable for banks have led to hundreds of lawsuits and an investigation by the U.K. Financial Services Authority into how they were sold. Unitech’s suit is one of the largest to reach the U.K. courts. The issue has affected bank customers from British seaside cafes to municipal governments including Milan in Italy and Jefferson County, Alabama.

Banks make a spread on swaps they transact with clients. In general they offset the rate risk with futures, bonds, or swaps in the other direction (usually some combination of these). A typical swaps desk is indifferent to the detection of rates. That means if the client loses money, doesn't mean the bank makes that same amount of money, because the bank is rate neutral. Unless of course the client refuses to pay.

This option to sue really comes in handy. Here is some investment advice: if you have a stock portfolio, hedge it with some S&P500 futures. If these futures make you money when your portfolio tanks, you've limited your losses. But if the futures lose money when the portfolio rallies, just sue the Chicago Mercantile Exchange. Wait, that might be a bit tough to do. Instead of futures, just enter into an equity index swap with some bank, and then sue it in some "friendly" jurisdiction. Just claim it wasn't well explained to you.

These swap sales people at banks need to be re-educated. They should only offer cancellable swaps to most clients. Such swaps allow a client to cancel the transactions if rates go against them. Cancellable swaps are clearly more expensive than the "vanilla" type because of that embedded option to cancel. But since many organizations already have a free embedded option to sue, the cancellable product is the way to go (see quick overview below).